Establish a PE Ratio

PE ratio reflects the price investors are willing to pay per rupee of EPS. It represents the markets evaluation of a companies prospects. The PE ratio may be derived from the constant growth dividend model or cross section analysis or historical analysis.

DIVIDEND PAYOUT RATIO AND DIVIDEND PER SHARE

Dividend Payout Ratio Equity dividends Equity earnings 20 x 5 20 x 6 30/60 = 0.50 20 x 7 30/70 = 0.43

Dividend Payout ratio

28/34 = 0.82

Dividend Per Share (DPS) 20 x 5 Rs 1.87 20 x 6 2.00 20 x 7 2.00

DPS

P / E RATIO

CONSTANT GROWTH DIVIDEND MODEL

DIVIDEND PAYOUT RATIO P / E RATIO =

REQUIRED RETURN ON EQUITY

EXPECTED GROWTH RATE IN DIVIDENDS

CROSS SECTION ANALYSIS

P/E

= a1 + a2 GROWTH RATE IN EARNING + a3 DIVIDEND PAYOUT RATIO + a4 VARIABILITY IN EARNINGS + a5 COMPANY SIZE

RATIO
HISTORICAL ANALYSIS
PE ratio 20 x 5 9.25 20 x 6 6.63 20 x 7 6.23

The average PE ratio is : 9.25 + 6.63 + 6.23 = 7.37 3

WEIGHTED PE RATIO PE ratio based on the constant growth dividend discount model : 6.36

PE ratio based on historical analysis : 7.37 6.36 + 7.37 = 6.87 2

VALUE ANCHOR AND VALUE RANGE

Value Anchor
Projected EPS x Appropriate PE ratio 5.00 x 6.87 = Rs. 34.35 Value Range Rs.30 Market Price < Rs.30 Rs.30 Rs.38 > Rs.38 Rs.38 Decision Buy Hold Sell

Tools for judging Undervaluation or Overvaluation

Investment practitioners have developed a variety of tools to judge whether a stock is undervalued or overvalued A few tools are briefly described : PBV-ROE MATRIX Growth duration matrix

PBV-ROE Matrix

HIGH PBV Ratio LOW

Overvalued Low ROE High PBV Low ROE Low PBV

High ROE High PBV

Undervalued High ROE Low PBV HIGH ROE

LOW

GROWTH-DURATION MATRIX

High
Expected 5-Yr EPS Growth Low

Undervalued

Promises of growth

Dividend cows Low

Overvalued

High

Duration (1/Dividend Yield)

EXPECTATIONS RISK INDEX (ERI) Developed by Al Rappaport, the ERI reflects the risk in realising the expectations embedded in the current market price

Proportion of stock
ERI = price depending on expected future growth X

Ratio of expected future

growth to recent growth (Acceleration ratio)

ERI ILLUSTRATION
Omegas price per share Omegas operating cash flow (before growth investment) Omegas cost of equity Growth rate in after-tax cash operating earnings over the past three years = Rs.150
= Rs.10 per share

= 15 percent

= 20 percent

Market expectation of the growth in after-tax cash operating earnings over the next three = 50 percent years

Cntd..
Rs.10 Omegas base line value = 0.15 = Rs.66.7 Proportion of the stock price coming 150 66.7 from investors expectations of future = = 0.56 150 growth opportunities 1.50 Acceleration ratio = 1.20 ERI = 0.56 x 1.25 = 0.70

= 1.25

In general, the lower (higher) the ERI, the greater (smaller) the chance of achieving expectations and the higher (lower) the expected return for investors.

OBSTACLES IN THE

WAY OF AN ANALYST
Inadequacies or incorrectness of data Future uncertainties

Irrational market behaviour

Thank you